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Chapter 7
As an entity increases its gearing i.e. the amount of debt in its capital
structure, two things happen to the cost of capital (WACC)
1 debt is a cheaper source of 2 the equity holders perceive
finance than equity (lower risk more risk caused by the
and tax relief on interest) so increase in debt, so the cost
the WACC falls by of equity rises and hence
introducing more debt WACC rises
The different gearing theories interpret the net effect of these two
factors in different ways.
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